The London Interbank Offered Rate (LIBOR) was once a globally accepted benchmark interest rate, playing a pivotal role in the financial industry. It represented the average interest rate at which major global banks borrowed from one another, spanning various currencies and maturities. However, the legacy of LIBOR is marred by manipulation, scandals, and concerns about its credibility. In this article, we will delve into the world of LIBOR, its calculation, uses, history, alternatives, and its eventual phase-out.

Understanding LIBOR

LIBOR encompassed five major currencies and seven different maturities, resulting in a total of 35 rates calculated daily. The rate was derived by asking major banks about the interest rates they would charge one another for short-term loans. The highest and lowest figures were removed, and the trimmed average was calculated and announced each day by the ICE Benchmark Administration (IBA). This dynamic rate influenced consumer loans, credit cards, car loans, and adjustable-rate mortgages. However, it also impacted the yields of securities and financial instruments tied to LIBOR.

How Is LIBOR Calculated?

The LIBOR calculation method evolved over time. In 2018, the IBA introduced the Waterfall Methodology to enhance its accuracy. This approach involved three levels:

1. Transaction-based calculation: This level considered a volume-weighted average price of eligible transactions, giving more weight to those closer to 11:00 a.m. London time.

2. Transaction-derived calculation: If a bank lacked sufficient eligible transactions for level 1, it would submit rates based on transaction-derived data.

3. Expert judgment: If a bank failed to provide rates in the first two levels, it would submit the rate at which it could finance itself at 11:00 a.m. London time.

The trimmed mean approach, eliminating the highest and lowest quartile figures, was retained for LIBOR calculation.

Uses of LIBOR

LIBOR had a profound impact on the financial world, playing a pivotal role in a wide range of financial products. It was used in standard interbank products, commercial products, hybrid products, consumer loan-related products, and as a gauge of market expectations for interest rates set by central banks. Many derivative products were also created and traded with reference to LIBOR.

A Brief History of LIBOR

The need for a uniform measure of interest rates in the 1980s led to the establishment of the British Bankers’ Association (BBA) interest-settlement rates in 1984. These rates evolved into BBA LIBOR in 1986, serving as the default standard interest rate for international and local financial dealings. Major changes occurred when the Intercontinental Exchange (ICE) took over the administration of LIBOR in 2014. During the 2008 financial crisis, the number of tenors for which LIBOR was calculated declined.

LIBOR Scandal of Rate Rigging

LIBOR's history is tainted by a scandal where major banks allegedly manipulated rates to their advantage. They submitted artificially low LIBOR rates to boost profits from their positions in LIBOR-based financial securities. This scandal led to regulatory investigations and hefty fines imposed on banks and their employees. It also contributed to the transition from BBA administration to ICE.

Benefits of Watching LIBOR Rates

Despite the controversies, LIBOR rates offered valuable insights into the global economy. A falling LIBOR signaled easier borrowing conditions, potentially indicating economic growth, while a rising LIBOR suggested tighter credit conditions and slower economic activity. These rates significantly influenced the interest rates borrowers faced, impacting their mortgages and personal loans.

Phasing Out LIBOR

In recent years, regulatory reforms sought to replace LIBOR with more transparent and transaction-based benchmark rates. The Secured Overnight Financing Rate (SOFR) emerged as LIBOR's replacement, based on actual observed transactions in the U.S. Treasury market. The transition aimed to eliminate the conjecture surrounding interest rates that was prevalent under LIBOR. The U.K. banks were no longer required to publish LIBOR rates after 2021, and the full phase-out occurred on June 30, 2023. Other countries are also exploring their own benchmark rates to replace LIBOR.

Examples of LIBOR-Based Products and Transactions

One of the most common examples of a LIBOR-based transaction is a floating rate bond, where the annual interest payment is based on LIBOR. Interest rate swaps, where parties exchange interest payments, also often involve LIBOR. These products and transactions allowed businesses and investors to manage interest rate risks and customize their income streams based on their preferences and market conditions.

In summary, while LIBOR was a dominant benchmark interest rate for decades, its phase-out marked a significant shift in the financial industry. The transition to more transparent and transaction-based rates aimed to enhance the integrity and reliability of interest rate benchmarks, reducing the potential for manipulation and scandal.

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